Interest rates are one of the most important factors that affect your financial decisions. Whether you are borrowing money to buy a home, saving money for a rainy day, or investing money for your future, interest rates can have a significant impact on your returns and costs.
But what are interest rates and how do they work? In this blog post, we will explain the different types of interest rates and what they mean to borrowers and savers.
What Are Interest Rates?
Interest rates are the amount of money that lenders charge borrowers for the use of their money, or that savers earn from depositing their money in a bank or credit union. Interest rates are usually expressed as a percentage of the principal amount per year.
For example, if you borrow $100,000 at an interest rate of 5% per year, you will have to pay $5,000 in interest every year until you repay the principal. Similarly, if you deposit $100,000 in a savings account that pays an interest rate of 2% per year, you will earn $2,000 in interest every year.
Interest rates can vary depending on several factors, such as the supply and demand of money in the market, the inflation rate, the creditworthiness of the borrower or saver, the duration and riskiness of the loan or deposit, and the monetary policy of the central bank.
Types of Interest Rates
There are different types of interest rates that apply to different financial products and situations. Some of the most common ones are:
- Prime rate: This is the interest rate that commercial banks charge their most creditworthy customers, usually large corporations. The prime rate influences other interest rates in the market, such as credit card rates and home equity loan rates.
- Federal funds rate: This is the interest rate that banks charge each other for overnight loans to meet their reserve requirements. The federal funds rate is set by the Federal Reserve (the central bank of the United States) through its monetary policy actions. The federal funds rate affects other short-term interest rates in the market, such as treasury bills and commercial paper.
- Discount rate: This is the interest rate that the Federal Reserve charges banks for loans from its discount window. The discount rate is usually higher than the federal funds rate to discourage banks from relying on it too much. The discount rate also influences other interest rates in the market.
- Mortgage rate: This is the interest rate that lenders charge borrowers for home loans. Mortgage rates depend on various factors, such as the type and term of the loan, the borrower's credit score and income, the value and location of
the property, and the prevailing market conditions. Mortgage rates can be fixed or adjustable.
- Savings rate: This is the interest rate that banks or credit unions pay savers for depositing their money in savings accounts or certificates of deposit (CDs). Savings rates depend on various factors, such as
the amount and duration of the deposit, the type of account, and
the prevailing market conditions. Savings rates can be fixed or variable.
How Interest Rates Affect Your Mortgage and Savings
Interest rates have a direct impact on your mortgage and savings. Here are some examples:
- If interest rates rise, your monthly mortgage payment will increase if you have an adjustable-rate mortgage (ARM). This means you will have less disposable income to spend or save. However,if you have a fixed-rate mortgage (FRM), your monthly payment will remain unchanged regardless of interest rate changes.
- If interest rates fall,your monthly mortgage payment will decrease if you have an ARM. This means you will have more disposable income to spend or save. However,
if you have an FRM,your monthly payment will remain unchanged regardless of interest rate changes.
- If interest rates rise,your savings will earn more interest if you have a variable-rate savings account or CD. This means you will have more money to spend or save in
the future. However,if you have a fixed-rate savings account or CD,
your savings will earn less interest compared to other options in
the market.
- If interest rates fall,your savings will earn less interest if you have a variable-rate savings account or CD. This means you will have less money to spend or save in
the future. However,if you have a fixed-rate savings account or CD,
your savings will earn more interest compared to other options in
the market.
As you can see, interest rates can affect your financial situation in different ways!